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HELOC: Understanding Home Equity Lines of Credit

HELOC: Understanding Home Equity Lines of Credit

A home equity line of credit is a second mortgage that turns home value into cash you can access as needed. HELOCs require a 620 credit score.

A home equity line of credit, also called a “HELOC” (HEE-lock), is a second mortgage that gives you access to a pool of cash, usually up to about 85% of your home’s value less the balance remaining on your mortgage.

The best reason to get a home equity line of credit is for something like a major repair or remodeling project that increases the value of your home. A reason not to get a HELOC is the risk of losing your home if you can’t pay back what you borrow.

To get a home equity line of credit, you’ll typically need a debt-to-income ratio in the lower 40s or less, a credit score of 620 or higher and home value of 10% to 20% more than you owe.

How a HELOC works

Much like a credit card that allows you to borrow against your spending limit as often as needed, a HELOC gives you the flexibility to borrow against your home equity, repay and repeat.

Say you have a $500,000 home with a balance of $300,000 on your first mortgage and your lender is allowing you to access up to 85% of your home’s equity. You can establish a HELOC with up to a $125,000 limit:

  • $500,000 x 85% = $425,000
  • $425,000 – $300,000 = $125,000, your maximum line of credit limit

Most HELOCs have variable interest rates. This means that as baseline interest rates go up or down, the interest rate on your HELOC will adjust, too.

To set your rate, the lender will start with an index rate, like the prime rate or Libor (a benchmark rate used by many banks), then add a markup depending on your credit profile. Variable rates leave you vulnerable to rising interest rates, so be sure to take this into account.

How a HELOC affects your credit score

Although a HELOC acts a lot like a credit card, giving you ongoing access to your home’s equity, there’s one big difference when it comes to your credit score: Some bureaus treat HELOCs of a certain size like installment loans rather than revolving lines of credit.

This means borrowing 100% of your HELOC limit may not have the same negative effect as maxing out your credit card. Like any line of credit, a new HELOC on your report will likely reduce your credit score temporarily.

Reasons to get a home equity line of credit

A HELOC is best used for home repairs and upgrades. While it’s tempting to tap the easy-as-using-a-debit-card convenience of a HELOC for all sorts of things — a vacation, a new car, whatever — those splurges aren’t wealth-building uses of your home’s value and may put you at risk of losing the house if you default on the loan.

A bonus: The interest on your HELOC may be tax-deductible if you use the money to buy, build or substantially improve your home, according to the IRS.

Reasons to avoid a home equity line of credit

Sure, you could also use a HELOC to help you meet financial goals — consolidating credit card debt, starting a new business or paying your child’s college tuition — but doing so is rarely wise.

Though a HELOC may offer a lower interest rate, it also introduces the risk of foreclosure if you can’t pay the loan. Consider tapping an emergency fund or taking out a personal loan instead.

Regardless of your goal, always avoid a HELOC if:

Your income is unstable. If it’s possible that your income will change for the worse at any point during the loan, a HELOC may be a bad idea. If you can’t keep up with your monthly payments, a lender might force you out of your home. Foreclosure laws concerning timing and procedures vary by state.

Also, your bank may decide to freeze your HELOC if your home dramatically loses value or the bank reasonably believes you won’t be able to repay the loan. A frozen HELOC doesn’t mean foreclosure, but it does cut off the line of credit.

You can’t afford the upfront costs. Taking out a HELOC can be expensive. You have to pay many of the same fees that you did when you took out your first mortgage. These include an application fee, title search, appraisal, attorney’s fees and points. In total, these charges can set you back hundreds of dollars.

You aren’t looking to borrow much money. Those heavy upfront costs mentioned above may not be worth it if you only need a small line of credit. In that case, you may be better off with a low-interest credit card, perhaps with an introductory interest-free period.

You can’t afford an interest-rate increase. Unless you can get a fixed-rate HELOC — and those are rare — you need to prepare for the interest rates to rise over the course of the loan. All adjustable-rate loans have lifetime caps; those indicate the interest rate’s upper limit. Can you pay that rate? If not, think twice about getting the loan. Also, see if your loan will have a periodic cap. This is the maximum amount your interest rate can rise in a given time period. How quickly could your interest rate, and the monthly payment, rise? Make sure your budget can manage it.

You’re using it for basic needs. If you need extra money for day-to-day purchases, and you’re having trouble just making ends meet, a HELOC isn’t worth the risk. Get your finances in shape before taking on additional debts.